##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
   FORM 10-Q
 
 (Mark One) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2004 or [  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to Commission File No. 000-25805 Fauquier Bankshares, Inc.  Virginia
    
    54-1288193(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)10 Courthouse SquareWarrenton, Virginia
    
    20186(Address of principal executive offices)
    
    (Zip Code)
 (540) 347-2700
(Registrants telephone number, including area code) Not Applicable
(Former name, former address and former fiscal year, if changed since last report)




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##### 



Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X]  No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [  ]  No [X]

As of August 7, 2004, the latest practicable date for determination,
3,323,772 shares of common stock, par value $3.13 per share, of the registrant
were outstanding.



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##### 



FAUQUIER BANKSHARES, INC. INDEX PagePart I. FINANCIAL INFORMATION
    
    
    2Item 1. Financial Statements
    
    
    2Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December
31, 2003
    
    
    2Consolidated Statements of Income (unaudited) for the Three Months Ended
June 30, 2004 and 2003
    
    
    3Consolidated Statements of Income (unaudited) for the Six Months Ended
June 30, 2004 and 2003
    
    
    4Consolidated Statements of Changes in Shareholders Equity (unaudited)
for the Six Months Ended June 30, 2004 and 2003
    
    
    5Consolidated Statements of Cash Flows (unaudited) for the Six Months Ended
June 30, 2004 and 2003
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    27Item 4. Controls and Procedures
    
    
    27Part II. OTHER INFORMATION
    
    
    28Item 1. Legal Proceedings
    
    
    28Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    28Item 3. Defaults Upon Senior Securities
    
    
    28Item 4. Submission of Matters to a Vote of Security Holders
    
    
    28Item 5. Other Information
    
    
    29Item 6. Exhibits and Reports on Form 8-K
    
    
    29SIGNATURES
    
    
    30
 1
      Part I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS Fauquier Bankshares, Inc. and Subsidiaries 
 Consolidated Balance Sheets
 Unaudited
    
    AuditedJune 30, 2004
    
    December 31, 2003AssetsCash and due from banks
    
    $
    23,863,349
    
    
    $
    11,808,387Interest-bearing deposits in other banks
    
    
    209,703
    
    
    
    142,042Federal funds sold
    
    
    1,740,000
    
    
    
    Securities, at fair value
    
    
    52,032,855
    
    
    
    52,386,006Loans, net of allowance for loan losses of $3,801,691
in 2004 and $3,575,002 in 2003
    
    
    316,207,476
    
    
    
    295,311,745Bank premises and equipment, net
    
    
    8,657,409
    
    
    
    7,875,424Accrued interest receivable
    
    
    1,279,030
    
    
    
    1,233,004Other assets
    
    
    10,493,029
    
    
    
    9,703,670Total assets
    
    $
    414,482,851
    
    
    $
    378,460,278LiabilitiesDeposits:Noninterest-bearing
    
    $
    86,964,048
    
    
    $
    73,128,879Interest-bearing
    
    
    272,397,823
    
    
    
    247,999,697Total deposits
    
    $
    359,361,871
    
    
    $
    321,128,576Federal funds purchased
    
    
    21,000
    
    
    
    2,000,000Dividends payable
    
    
    
    
    
    
    430,590Federal Home Loan Bank advances
    
    
    20,000,000
    
    
    
    20,000,000Company-obligated mandatorily redeemable capital securities
    
    
    4,000,000
    
    
    
    4,000,000Other liabilities
    
    
    2,222,355
    
    
    
    2,438,327Commitments and contingent liabilities
    
    
    
    
    
    
    Total liabilities
    
    $
    385,605,226
    
    
    $
    349,997,493Shareholders EquityCommon stock, par value, $3.13; authorized 8,000,000 shares;
issued and outstanding, 2004, 3,322,226 shares; 2003, 3,312,230 shares
    
    
    10,398,567
    
    
    
    10,367,280Retained earnings
    
    
    18,862,587
    
    
    
    18,082,684Accumulated other comprehensive income(loss), net
    
    
    (383,529
    )
    
    
    12,821Total shareholders equity
    
    $
    28,877,625
    
    
    $
    28,462,785Total liabilities and shareholders equity
    
    $
    414,482,851
    
    
    $
    378,460,278
 See accompanying Notes to Consolidated Financial Statements. 2
      Fauquier Bankshares, Inc. and Subsidiaries 
 Consolidated Statements of Income
 (Unaudited)
For the Three Months Ended June 30, 2004 and 2003
 2004
    
    2003Interest IncomeInterest and fees on loans
    
    $
    4,865,129
    
    
    $
    4,126,471Interest and dividends on securities available for sale:Taxable interest income
    
    
    361,012
    
    
    
    378,356Interest income exempt from federal income taxes
    
    
    14,343
    
    
    
    18,375Dividends
    
    
    48,207
    
    
    
    61,894Interest on federal funds sold
    
    
    20,442
    
    
    
    33,599Interest on deposits in other banks
    
    
    11,533
    
    
    
    267Total interest income
    
    
    5,320,666
    
    
    
    4,618,962Interest ExpenseInterest on deposits
    
    
    792,425
    
    
    
    805,018Interest on federal funds purchased
    
    
    2,483
    
    
    
    Interest on Federal Home Loan Bank advances
    
    
    196,374
    
    
    
    175,807Distribution on capital securities of subsidiary trust
    
    
    47,802
    
    
    
    49,257Total interest expense
    
    
    1,039,084
    
    
    
    1,030,082Net interest income
    
    
    4,281,582
    
    
    
    3,588,880Provision for loan losses
    
    
    154,166
    
    
    
    155,000Net interest income after
provision for loan losses
    
    
    4,127,416
    
    
    
    3,433,880Other incomeWealth management income
    
    
    308,632
    
    
    
    216,020Service charges on deposit accounts
    
    
    636,870
    
    
    
    620,381Other service charges, commissions and fees
    
    
    289,033
    
    
    
    368,936Other operating income
    
    
    23,587
    
    
    
    10,378Total other income
    
    
    1,258,122
    
    
    
    1,215,715Other ExpensesSalaries and benefits
    
    
    1,951,551
    
    
    
    1,585,051Net occupancy expense of premises
    
    
    215,954
    
    
    
    206,418Furniture and equipment
    
    
    310,125
    
    
    
    292,577Other operating expenses
    
    
    1,354,505
    
    
    
    1,216,197Total other expenses
    
    
    3,832,135
    
    
    
    3,300,243Income before income taxes
    
    
    1,553,403
    
    
    
    1,349,352Income tax expense
    
    
    469,322
    
    
    
    403,154Net Income
    
    $
    1,084,081
    
    
    $
    946,198Earnings per Share, basic
    
    $
    0.33
    
    
    $
    0.28Earnings per Share, assuming dilution
    
    $
    0.31
    
    
    $
    0.27Dividends per Share
    
    $
    0.14
    
    
    $
    0.12
 See accompanying Notes to Consolidated Financial Statements. 3
      Fauquier Bankshares, Inc. and Subsidiaries 
 Consolidated Statements of Income
 (Unaudited)
For the Six Months Ended June 30, 2004 and 2003
 2004
    
    2003Interest IncomeInterest and fees on loans
    
    $
    9,590,001
    
    
    $
    8,104,995Interest and dividends on securities available for sale:Taxable interest income
    
    
    705,809
    
    
    
    908,382Interest income exempt from federal income taxes
    
    
    28,791
    
    
    
    38,037Dividends
    
    
    64,229
    
    
    
    121,347Interest on federal funds sold
    
    
    20,463
    
    
    
    36,739Interest on deposits in other banks
    
    
    18,260
    
    
    
    728Total interest income
    
    
    10,427,553
    
    
    
    9,210,228Interest ExpenseInterest on deposits
    
    
    1,524,079
    
    
    
    1,597,173Interest on federal funds purchased
    
    
    33,802
    
    
    
    5,381Interest on Federal Home Loan Bank advances
    
    
    407,254
    
    
    
    349,682Distribution on capital securities of subsidiary trust
    
    
    96,032
    
    
    
    99,257Total interest expense
    
    
    2,061,167
    
    
    
    2,051,493Net interest income
    
    
    8,366,386
    
    
    
    7,158,735Provision for loan losses
    
    
    308,333
    
    
    
    230,000Net interest income after
provision for loan losses
    
    
    8,058,053
    
    
    
    6,928,735Other incomeWealth management income
    
    
    633,321
    
    
    
    434,775Service charges on deposit accounts
    
    
    1,235,474
    
    
    
    1,252,439Other service charges, commissions and fees
    
    
    623,487
    
    
    
    642,433Other operating income
    
    
    24,317
    
    
    
    19,750Total other income
    
    
    2,516,599
    
    
    
    2,349,397Other ExpensesSalaries and benefits
    
    
    3,838,583
    
    
    
    3,171,348Net occupancy expense of premises
    
    
    427,718
    
    
    
    415,021Furniture and equipment
    
    
    609,517
    
    
    
    584,266Other operating expenses
    
    
    2,633,460
    
    
    
    2,211,141Total other expenses
    
    
    7,509,278
    
    
    
    6,381,776Income before income taxes
    
    
    3,065,374
    
    
    
    2,896,356Income tax expense
    
    
    911,356
    
    
    
    859,164Net Income
    
    $
    2,154,018
    
    
    $
    2,037,192Earnings per Share, basic
    
    $
    0.65
    
    
    $
    0.61Earnings per Share, assuming dilution
    
    $
    0.61
    
    
    $
    0.59Dividends per Share
    
    $
    0.27
    
    
    $
    0.23
 See accompanying Notes to Consolidated Financial Statements. 4
      Fauquier Bankshares, Inc. and Subsidiaries 
 Consolidated Statements of Changes in Shareholders Equity
 (Unaudited)
For the Six Months Ended June 30, 2004 and 2003
 AccumulatedOtherCommon
    
    Capital
    
    Retained
    
    Comprehensive
    
    ComprehensiveStock
    
    Surplus
    
    Earnings
    
    Income (Loss)
    
    Income
    
    TotalBalance, December 31, 2002
    
    $
    10,341,726
    
    
    $
    
    
    
    $
    15,419,307
    
    
    $
    670,132
    
    
    
    
    
    
    $
    26,431,165Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    2,037,192
    
    
    
    
    
    
    $
    2,037,192
    
    
    
    2,037,192Other comprehensive income net of tax:Unrealized holding losses on securities available
for sale, net of deferred income taxes of $158,521
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (307,718
    )
    
    
    (307,718
    )
    
    
    (307,718
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    1,729,474
    
    
    
    Cash dividends
    
    
    
    
    
    
    
    
    
    
    (760,220
    )
    
    
    
    
    
    
    
    
    
    
    (760,220
    )Acquisition of 9,900 shares of common stock
    
    
    (30,987
    )
    
    
    
    
    
    
    (123,397
    )
    
    
    
    
    
    
    
    
    
    
    (154,384
    )Exercise of stock options
    
    
    53,142
    
    
    
    
    
    
    
    79,095
    
    
    
    
    
    
    
    
    
    
    
    132,237Balance, June 30, 2003
    
    $
    10,363,881
    
    
    $
    
    
    
    $
    16,651,977
    
    
    $
    362,414
    
    
    
    
    
    
    $
    27,378,272Balance, December 31, 2003
    
    $
    10,367,280
    
    
    $
    
    
    
    $
    18,082,684
    
    
    $
    12,821
    
    
    
    
    
    
    $
    28,462,785Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    2,154,018
    
    
    
    
    
    
    $
    2,154,018
    
    
    
    2,154,018Other comprehensive income net of tax:Unrealized holding loss on securities available
for sale, net of deferred income taxes of $204,180
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (396,350
    )
    
    
    (396,350
    )
    
    
    (396,350
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    1,757,668
    
    
    
    Cash dividends
    
    
    
    
    
    
    
    
    
    
    (896,359
    )
    
    
    
    
    
    
    
    
    
    
    (896,359
    )Acquisition of 30,570 shares of common stock
    
    
    (95,684
    )
    
    
    
    
    
    
    (601,147
    )
    
    
    
    
    
    
    
    
    
    
    (696,831
    )Net issuance of restricted stock, less amortization
    
    
    39,304
    
    
    
    
    
    
    
    (498
    )
    
    
    
    
    
    
    
    
    
    
    38,806Exercise of stock options
    
    
    87,668
    
    
    
    
    
    
    
    123,888
    
    
    
    
    
    
    
    
    
    
    
    211,556Balance, June 30, 2004
    
    $
    10,398,568
    
    
    $
    
    
    
    $
    18,862,586
    
    
    $
    (383,529
    )
    
    
    
    
    
    $
    28,877,625
 See accompanying Notes to Consolidated Financial Statements. 5
      Fauquier Bankshares, Inc. and Subsidiaries 
 Consolidated Statements of Cash Flows
 (Unaudited)
For the Six Months Ended June 30, 2004 and 2003
 2004
    
    2003Cash Flows from Operating ActivitiesNet income
    
    $
    2,154,018
    
    
    $
    2,037,192Adjustments to reconcile net income to net
cash provided by operating activities:Depreciation and amortization
    
    
    532,956
    
    
    
    504,312Provision for loan losses
    
    
    308,333
    
    
    
    230,000(Gain) on sale of premises and equipment
    
    
    (5,910
    )
    
    
    Amortization of security premiums and (accretion) of
discounts, net
    
    
    168,701
    
    
    
    452,803Changes in assets and liabilities:(Increase) in other assets
    
    
    (490,624
    )
    
    
    (337,934
    )Increase (Decrease) in other liabilities
    
    
    (215,972
    )
    
    
    111,531Net cash provided by operating activities
    
    
    2,451,502
    
    
    
    2,997,904Cash Flows from Investing ActivitiesProceeds from maturities, calls and principal
payments of securities available for sale
    
    
    10,118,697
    
    
    
    23,295,390Purchase of securities available for sale
    
    
    (10,534,777
    )
    
    
    (18,231,870
    )Proceeds from sale of premises and equipment
    
    
    5,910
    
    
    
    Purchase of premises and equipment
    
    
    (1,314,941
    )
    
    
    (1,880,157
    )Purchase of Bank Owned Life Insurance
    
    
    
    
    
    
    (5,000,000
    )Net (increase) in loans
    
    
    (21,344,645
    )
    
    
    (34,491,359
    )Net cash (used in) investing activities
    
    
    (23,069,756
    )
    
    
    (36,307,996
    )Cash Flows from Financing ActivitiesNet increase in demand deposits, NOW accounts
and savings accounts
    
    
    39,431,206
    
    
    
    34,292,453Net increase (decrease) in certificates of deposit
    
    
    (1,197,911
    )
    
    
    11,582,735Proceeds from Federal Home Loan Bank advances
    
    
    9,000,000
    
    
    
    Repayment of Federal Home Loan Bank advances
    
    
    (9,000,000
    )
    
    
    Proceeds from Federal Funds Purchased
    
    
    21,000
    
    
    
    Repayment of Federal Funds Purchased
    
    
    (2,000,000
    )
    
    
    Cash dividends paid
    
    
    (1,326,949
    )
    
    
    (726,330
    )Issuance of common stock
    
    
    250,362
    
    
    
    132,237Acquisition of common stock
    
    
    (696,831
    )
    
    
    (154,384
    )Net cash provided by financing activities
    
    
    34,480,877
    
    
    
    45,126,711Increase (decrease) in cash and cash equivalents
    
    
    13,862,623
    
    
    
    11,816,619Cash and Cash EquivalentsBeginning
    
    
    11,950,429
    
    
    
    24,937,080Ending
    
    $
    25,813,052
    
    
    $
    36,753,699Supplemental Disclosures of Cash Flow InformationCash payments for:Interest
    
    $
    2,033,270
    
    
    $
    2,071,631Income taxes
    
    $
    791,000
    
    
    $
    641,000Supplemental Disclosures of Noncash Investing ActivitiesUnrealized (loss) on securities available for sale, net
    
    $
    (600,530
    )
    
    $
    (466,134
    )
 See accompanying Notes to Consolidated Financial Statements. 6
      FAUQUIER BANKSHARES, INC. AND SUBSIDIARIES 
 Notes to Consolidated Financial Statements  1.
    
    GeneralThe consolidated statements include the accounts of Fauquier
Bankshares, Inc. (the Corporation) and its wholly-owned subsidiary,
The Fauquier Bank (the Bank), of which Fauquier Bank Services, Inc. is its sole subsidiary. In consolidation, significant
intercompany financial balances and transactions have been eliminated. In the opinion of management, the
accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring
accruals) necessary to present fairly the financial positions as of June 30, 2004 and December 31, 2003, and the
results of operations and cash flows for the six months ended June 30, 2004 and 2003.
The results of operations for the six and three months ended June 30, 2004 and 2003 are not necessarily indicative of the
results expected for the full year.2.
    
    SecuritiesThe amortized cost of securities available for sale, with unrealized gains and losses follows: Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    (Losses)
    
    ValueJune 30, 2004Obligations of U.S.
Government corporations
and agencies
    
    $
    44,326,800
    
    
    $
    100,427
    
    
    $
    (559,888
    )
    
    $
    43,867,339Obligations of states and political
subdivisions
    
    
    1,162,480
    
    
    
    39,135
    
    
    
    
    
    
    
    1,201,615Corporate Bonds
    
    
    5,000,000
    
    
    
    
    
    
    
    (90,000
    )
    
    
    4,910,000Other
    
    
    252,875
    
    
    
    
    
    
    
    (7,674
    )
    
    
    245,201Restricted investments:Federal Home Loan
Bank stock
    
    
    1,262,200
    
    
    
    
    
    
    
    
    
    
    
    1,262,200Federal Reserve Bank
stock
    
    
    72,000
    
    
    
    
    
    
    
    
    
    
    
    72,000Community Bankers
Bank stock
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    50,000FHLMC Preferred
Bank stock
    
    
    487,500
    
    
    
    
    
    
    
    (63,000
    )
    
    
    424,500$
    52,613,855
    
    
    $
    139,562
    
    
    $
    (720,562
    )
    
    $
    52,032,855
 7
      Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    (Losses)
    
    ValueDecember 31, 2003Obligations of U.S.
Government corporations
and agencies
    
    $
    46,592,397
    
    
    $
    254,827
    
    
    $
    (208,599
    )
    
    $
    46,638,625Obligations of states and political
subdivisions
    
    
    1,164,580
    
    
    
    72,001
    
    
    
    
    
    
    
    1,236,581Corporate Bonds
    
    
    3,000,000
    
    
    
    
    
    
    
    (71,200
    )
    
    
    2,928,800Restricted investments:Federal Home Loan
Bank stock
    
    
    1,000,000
    
    
    
    
    
    
    
    
    
    
    
    1,000,000Federal Reserve Bank
stock
    
    
    72,000
    
    
    
    
    
    
    
    
    
    
    
    72,000Community Bankers
Bank stock
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    50,000FHLMC Preferred
Bank stock
    
    
    487,500
    
    
    
    
    
    
    
    (27,500
    )
    
    
    460,000$
    52,366,477
    
    
    $
    326,828
    
    
    $
    (307,299
    )
    
    $
    52,386,006
 The amortized cost and fair value of securities available for sale, by
contractual maturity, are shown below. Expected maturities may differ from
contractual maturities because issuers may have the right to call or prepay
obligations without penalties. June 30, 2004Amortized
    
    FairCost
    
    ValueDue in one year or less
    
    $
    486,504
    
    
    $
    479,517Due after one year through five years
    
    
    15,740,859
    
    
    
    15,496,984Due after five years through ten years
    
    
    4,881,359
    
    
    
    4,764,979Due after ten years
    
    
    29,633,433
    
    
    
    29,482,675Equity securities
    
    
    1,871,700
    
    
    
    1,808,700$
    52,613,855
    
    
    $
    52,032,855
 8
      The
following table shows the Corporations investments with gross unrealized losses and their fair value, aggregated by investment category and the length of time that individual securities have been in a
continuous unrealized loss position, at June 30, 2004 Less Than 12 Months
    
    12 Months or More
    
    TotalUnrealized
    
    
    
    
    
    Unrealized
    
    
    
    
    
    UnrealizedDescription of Securities
    
    Fair Value
    
    (Losses)
    
    Fair Value
    
    (Losses)
    
    Fair Value
    
    (Losses)Obligations of U.S. government
corporations and agencies
    
    $
    28,018,519
    
    
    $
    (547,837
    )
    
    $
    2,015,014
    
    
    $
    (11,851
    )
    
    $
    30,033,533
    
    
    $
    (559,688
    )Corporate bonds
    
    
    2,910,000
    
    
    
    (90,000
    )
    
    
    
    
    
    
    
    
    
    
    2,910,000
    
    
    
    (90,000
    )Subtotal, debt securities
    
    
    30,928,519
    
    
    
    (637,837
    )
    
    
    2,015,014
    
    
    
    (11,851
    )
    
    
    32,943,533
    
    
    
    (649,688
    )Preferred Stock
    
    
    487,500
    
    
    
    (63,000
    )
    
    
    
    
    
    
    
    
    
    
    487,500
    
    
    
    (63,000
    )Mutual Fund
    
    
    252,875
    
    
    
    (7,674
    )
    
    
    
    
    
    
    
    
    
    
    252,875
    
    
    
    (7,674
    )Total temporary impaired securities
    
    $
    31,668,894
    
    
    $
    (708,511
    )
    
    $
    2,015,014
    
    
    $
    (11,851
    )
    
    $
    33,683,908
    
    
    $
    (720,362
    )
 The nature of the securities which are temporarily impaired can be segmented into four groups. The first group consists of four
Federal Agency securities totaling $11.0 million with a temporary loss of $276,436. The securities within this group
have maturity dates ranging from 30 months to 47 months. Three of the securities within this group have call dates ranging
from one month to 12 months. The Corporation has the ability to hold these bonds to their call date or their maturity. The second group consists of three Federal agency mortgage-backed securities and five Federal agency collateralized
mortgage obligation securities totaling $16.4 million with a temporary loss of $283,252. The securities within this group
have estimated maturity dates ranging from 22 months to 96 months, and return principal on a monthly basis representing the repayment
and prepayment of the underlying mortgages. The Corporation has the ability to hold these bonds to their maturity. The third group consists of two corporate bonds, rated A2 by Moodys, totaling $3.0 million with a temporary loss of $90,000.
This bond has a remaining maturity of approximately 29 years, but can be called at par on its five year anniversary. If not called,
the bond reprices every three months at a fixed index above LIBOR. The Corporation has the ability to hold this bond to its maturity. The
final security is preferred stock with Freddie Mac totaling $487,500 with a temporary loss of $63,000. The Corporation has
the ability to hold this stock. 9
      3.
    
    LoansA summary of the balances of loans follows: June 30,
    
    December 31,2004
    
    2003(Thousands)Real estate loans:Construction
    
    $
    25,514
    
    
    $
    21,243Secured by farmland
    
    
    1,337
    
    
    
    1,329Secured by 1-4 family residential
    
    
    128,947
    
    
    
    119,116Other real estate loans
    
    
    89,371
    
    
    
    81,884Commercial and industrial loans (except those secured by real estate)
    
    
    23,960
    
    
    
    21,070Consumer installment loans
    
    
    42,538
    
    
    
    41,429All other loans
    
    
    8,657
    
    
    
    13,033Total loans
    
    $
    320,324
    
    
    $
    299,104Less: Unearned income
    
    
    315
    
    
    
    217Allowance for loan losses
    
    
    3,802
    
    
    
    3,575Net loans
    
    $
    316,207
    
    
    $
    295,312
  Analysis of the allowance for loan losses follows: Six Months
    
    Six Months
    
    Twelve MonthsEnding
    
    Ending
    
    EndingJune 30,
    
    June 30,
    
    December 31,2004
    
    2003
    
    2003Balance at beginning of period
    
    $
    3,575,002
    
    
    $
    2,909,607
    
    
    $
    2,909,607Provision charged to operating expense
    
    
    308,333
    
    
    
    230,000
    
    
    
    784,000Recoveries added to the allowance
    
    
    14,500
    
    
    
    100,776
    
    
    
    160,089Loan losses charged to the allowance
    
    
    (96,144
    )
    
    
    (119,856
    )
    
    
    (278,694
    )Balance at end of period
    
    $
    3,801,691
    
    
    $
    3,120,527
    
    
    $
    3,575,002
  Nonperforming assets consist of the following: June 30,
    
    December 31,2004
    
    2003(Thousands)Nonaccrual loans
    
    $
    828
    
    
    $
    962Restructured loans
    
    
    
    
    
    
    Total non-performing loans
    
    
    828
    
    
    
    962Foreclosed property
    
    
    140
    
    
    
    Total non-performing assets
    
    $
    968
    
    
    $
    962
  Total loans past due 90 days or more and still accruing interest totaled $260,000 on June 30, 2004 and
$840,000 on December 31, 2003, respectively. 10
      4.
    
    Company-Obligated Mandatorily Redeemable Capital Securities of Subsidiary TrustOn March 26, 2002, the Companys wholly-owned Connecticut statutory business trust privately issued $4 million face amount
of the trusts Floating Rate Capital Securities (Capital Securities) in a pooled capital securities offering. Simultaneously, the
trust used the proceeds of that sale to purchase $4 million principal amount of the Companys Floating Rate Junior Subordinated
Deferrable Interest Debentures due 2032 (Subordinated Debentures). Both the Capital Securities and the Subordinated Debentures
are callable at any time after five years from the issue date. The Subordinated Debentures are an unsecured obligation of the
Company and are junior in right of payment to all present and future senior indebtedness of the Company. The Capital Securities
are guaranteed by the Company on a subordinated basis.The Capital Securities are presented in the consolidated balance sheets of the Company under the caption Company-Obligated
Mandatorily Redeemable Capital Securities. The Company records distributions payable on the Capital Securities as an Interest
Expense in its consolidated statements of income. The cost of issuance of the Capital Securities was approximately $128,000.
This cost is being amortized over a five year period from the issue date.5.
    
    Earnings Per ShareThe following table shows the weighted average number of shares used in computing earnings per share and the
effect on weighted average number of shares of dilutive potential common stock. Dilutive potential common stock
had no effect on income available to common shareholders. Three Months
    
    Six Months
    
    Six MonthsEnding
    
    Ending
    
    EndingJune 30, 2004
    
    June 30, 2004
    
    June 30, 2003Per Share
    
    
    
    
    
    Per Share
    
    
    
    
    
    Per ShareShares
    
    Amount
    
    Shares
    
    Amount
    
    Shares
    
    AmountBasic earnings per share
    
    
    3,317,253
    
    
    $
    0.33
    
    
    
    3,314,255
    
    
    $
    0.65
    
    
    
    3,304,165
    
    
    $
    0.61Effect of dilutive securities, stock options
    
    
    181,665
    
    
    
    
    
    
    
    195,767
    
    
    
    
    
    
    
    166,178Diluted earnings per share
    
    
    3,498,918
    
    
    $
    0.31
    
    
    
    3,510,022
    
    
    $
    0.61
    
    
    
    3,470,343
    
    
    $
    0.59
  6.
    
    Stock-Based CompensationAt June 30, 2004, the Corporation has one stock-based compensation plan. The Corporation accounts for the plan under the recognition and measurement principles of APB Opinion 25, Accounting for Stock Issued to
Employees,and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the
underlying common stock on the date of the grant. The following table illustrates the effect on net income and earnings per share for the Corporation had the fair value recognition provisions of FASB
Statement No. 12, Accounting for Stock-Based Compensation, been applied to stock-based compensation. June 30,
    
    June 30,2004
    
    2003Net income , as reported
    
    $
    2,154,018
    
    
    $
    2,037,192Deduct: total stock-based employee compensation
expense determined based on fair value
method of awards, net of tax
    
    
        (34,937
    )
    
    
        (82,849
    )Pro forma net income
    
    $
        2,119,081
    
    
    $
        1,954,343Earnings per share:Basic - as reported
    
    $
        0.65
    
    
    $
        0.61Basic - pro forma
    
    $
        0.64
    
    
    $
        0.59Diluted - as reported
    
    $
        0.61
    
    
    $
        0.59Diluted - pro forma
    
    $
        0.60
    
    
    $
        0.56
 11
      7.
    
    Employee Benefit PlanThe following table provides a reconciliation of the changes in the defined benefit plans obligations for the
periods ending June 30, 2004 and 2003. Six Months EndedJune 30,2004
    
    2003Service cost
    
    $
    227,918
    
    
    $
    185,874Interest cost
    
    
    202,846
    
    
    
    180,218Expected return on plan assets
    
    
    (196,574
    )
    
    
    (154,888
    )Amortization of transition obligation/(asset)
    
    
    (9,490
    )
    
    
    (9,490
    )Amortization of prior service cost
    
    
    3,884
    
    
    
    3,884Recognized net actuarial (gain)/loss
    
    
    19,678
    
    
    
    25,416Net periodic benefit cost
    
    $
    248,262
    
    
    $
    231,014
  The Corporation previously disclosed in its financial statements for the year ended December 31, 2003, that it expected to contribute $68,000 to its pension plan in 2004. As of June 30, 2004, contributions
totaling $412,000 have been made. The Corporation presently anticipates no additional contributions to fund its pension plan in 2004. 12
      ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION In
addition to the historical information contained herein, this report contains
forward-looking statements. Forward-looking statements are based on certain
assumptions and describe future plans, strategies, and expectations of
management, and are generally identifiable by use of the words believe,
expect, intend, anticipate, estimate, project, may, will or
similar expressions. Although we believe our plans, intentions and
expectations reflected in these forward-looking statements are reasonable, we
can give no assurance that these plans, intentions, or expectations will be
achieved. Our ability to predict results or the actual effect of future plans
or strategies is inherently uncertain, and actual results could differ
materially from those contemplated. Factors that could have a material adverse
effect on our operations and future prospects include, but are not limited to,
changes in: interest rates, general economic conditions, the
legislative/regulatory climate, monetary and fiscal policies of the U.S.
Government, including the policies of the U.S. Treasury and the Board of
Governors of the Federal Reserve System, the quality or composition of The
Fauquier Banks (TFB) loan or investment portfolios, demand for loan
products, deposit flows, competition, demand for financial services in our
market area, and accounting principles, policies and guidelines. These risks
and uncertainties should be considered in evaluating forward-looking statements
in this report, and you should not place undue reliance on such statements,
which reflect our position as of the date of this report. GENERAL Fauquier
Bankshares, Inc. (Bankshares) was incorporated under the laws of the
Commonwealth of Virginia on January 13, 1984. Bankshares is a registered bank
holding company and owns all of the voting shares of TFB, a Virginia
state-chartered bank that commenced operations in 1902. Bankshares engages in
its business through TFB, and has no significant operations other than owning
the stock of TFB. Bankshares had issued and outstanding 3,322,226 shares of
common stock, par value $3.13 per share, held by approximately 394 holders of
record on June 30, 2004. TFB has eight full service branch offices located in the Virginia communities
of Warrenton, Catlett, The Plains, New Baltimore, Sudley Road-Manassas, Old
Town-Manassas and Bealeton. The branch in Bealeton opened during May 2004. The
executive offices of Bankshares and the main office of TFB are located at 10
Courthouse Square, Warrenton, Virginia 20186. TFBs general market area principally includes Fauquier County, western Prince
William County, and neighboring communities and is located approximately fifty
(50) miles southwest of Washington, D.C. TFB provides a range of consumer and commercial banking services to individuals
and businesses. The deposits of TFB are insured up to applicable limits by the
Bank Insurance Fund of the Federal Deposit Insurance Fund (the FDIC). The
basic services offered by TFB include: demand deposit accounts, savings and
money market deposit accounts, NOW accounts, time deposits, safe deposit
services, credit cards, cash management, automated clearing house services
(ACH) including direct deposits, notary services, night depository,
travelers checks, cashiers checks, domestic collections, savings bonds,
automated teller services, drive-in tellers, internet banking, banking by
telephone, and banking by mail. In addition, TFB makes secured and unsecured
commercial and real estate loans, issues stand-by letters of credit and grants
available credit for installment, unsecured and secured personal loans,
residential mortgages and home equity loans, as well as automobile and other
types of consumer financing. TFB provides automated teller machine (ATM)
cards, as a part of the Star and Plus ATM networks, thereby permitting
customers to utilize the convenience of larger ATM networks. 13
      TFB operates a Wealth Management Services (WMS) division that began with the
granting of trust powers to TFB in 1919. The WMS division provides personalized
services that include investment management, trust, estate settlement,
retirement, insurance, and brokerage services. TFB, through its subsidiary
Fauquier Bank Services, Inc., has equity ownership interests in Bankers
Insurance, LLC, a Virginia independent insurance company, and Bankers
Investments Group, LLC, a full service broker/dealer. Bankers Insurance
consists of a consortium of 56 Virginia community bank owners and Bankers
Investments Group is owned by 29 Virginia community banks. The revenues of TFB are primarily derived from interest and fees received on
real estate and other loans; interest and dividends from investment and
mortgage-backed securities; and fees on deposit products and WMS services. The
principal sources of funds for TFBs lending activities are its deposits,
repayment of loans, the sale and maturity of investment securities, and
borrowings from the Federal Home Loan Bank (FHLB) of Atlanta and other banks.
The principal expenses of TFB are the interest paid on deposits and
borrowings, and operating and general administrative expenses. As is the case with banking institutions generally, TFBs operations are
materially and significantly influenced by general economic conditions and by
related monetary and fiscal policies of financial institution regulatory
agencies, including the Board of Governors of the Federal Reserve System
(Federal Reserve). As a Virginia-chartered bank and a member of the Federal
Reserve, TFB is supervised and examined by the Federal Reserve and the Virginia
State Corporation Commission (SCC). Interest rates on competing investments
and general market rates of interest influence deposit flows and costs of
funds. Lending activities are affected by the demand for financing of real
estate and other types of loans, which in turn is affected by the interest
rates at which such financing may be offered and other factors affecting local
demand and availability of funds. TFB faces strong competition in the
attraction of deposits (its primary source of lendable funds) and in the
origination of loans. CRITICAL ACCOUNTING POLICIES GENERAL.Bankshares financial statements are prepared in accordance with
accounting principles generally accepted in the United States (GAAP). The
financial information contained within our statements is, to a significant
extent, based on measures of the financial effects of transactions and events
that have already occurred. A variety of factors could affect the ultimate
value that is obtained either when earning income, recognizing an expense,
recovering an asset or relieving a liability. We use historical loss factors
as one factor in determining the inherent loss that may be present in our loan
portfolio. Actual losses could
differ significantly from the historical factors that we use in our estimates.
In addition, GAAP itself may change from one previously acceptable accounting
method to another method. Although the economics of our transactions would be
the same, the timing of events that would impact our transactions could change. ALLOWANCE FOR LOAN LOSSES.The allowance for loan losses is an estimate of the
losses that may be sustained in our loan portfolio. The allowance is based on
two basic principles of accounting: (i) Statement of Financial Accounting
Standards (SFAS) No. 5 Accounting for Contingencies, which requires that
losses be accrued when they are probable of occurring and estimable and (ii)
SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which
requires that losses be accrued based on the differences between the value of
collateral, present value of future cash flows or values that are observable in
the secondary market and the loan balance. Our allowance for loan losses has three basic components: the specific
allowance, the formula allowance and the unallocated allowance. Each of these
components is determined based upon estimates that can and do change when the
actual events occur. The specific allowance is used to individually allocate an allowance for larger
balance, non-homogeneous loans. The specific allowance uses various techniques
to arrive at an estimate of loss. First, analysis of the borrowers overall
financial condition, resources and payment record, the prospects for support
from financial guarantors; and the fair market value of collateral are used to
estimate the probability and severity of inherent losses. Additionally, the
migration of historical default rates and loss severities, internal risk
ratings, industry and market conditions and trends, and other environmental
factors are considered. The use of these values is inherently subjective and
our actual losses could be greater or less than the estimates. 14
      The formula allowance is used for estimating the loss on pools of
smaller-balance, homogeneous loans; including 1-4 family mortgage loans,
installment loans, other consumer loans, and outstanding loan commitments.
Also, the formula allowance is used for the remaining pool of larger balance,
non-homogeneous loans which were not allocated a specific allowance upon their
review. The formula allowance begins with estimates of probable losses inherent
in the homogeneous portfolio based upon various statistical analyses. These
include analysis of historical and peer group delinquency and credit loss
experience, together with analyses that reflect current trends and conditions.
We also consider trends and changes in the volume and term of loans, changes in
the credit process and/or lending policies and procedures, and an evaluation of
overall credit quality. The formula allowance uses a historical loss view as an
indicator of future losses. As a result, even though this history is regularly
updated with the most recent loss information, it could differ from the loss
incurred in the future. The unallocated allowance captures losses that are attributable to various
economic events, industry or geographic sectors whose impact on the portfolio
have occurred but have yet to be recognized in either the formula or specific
allowances. In addition, an unallocated reserve is maintained to recognize the
imprecision in estimating and measuring inherent losses on individual loans or
pools of loans. EXECUTIVE OVERVIEW This discussion is intended to focus on certain financial information regarding
Bankshares and TFB and may not contain all the information that is important to
the reader. The purpose of this discussion is to provide the reader with a more
thorough understanding of our financial statements. As such, this discussion
should be read carefully in conjunction with the consolidated financial
statements and accompanying notes contained elsewhere in this report. Through the merger and consolidation of other area banks, TFB has become the
primary independent community bank in its immediate geographic market. TFB
continually seeks to be the principal financial service provider for its market
area by providing high quality customer service, efficient technological
support, value-added products, and a strong commitment to the community. Net income of $1.08 million for the quarter ending June 30, 2004 was a 14.6%
increase from the June 2003 quarter net income of $0.95 million. Net income for
the six months ended June 30, 2004 was $2.15 million or $0.61 per diluted share
compared with $2.04 million or $0.59 per diluted share for the six months ended
June 30, 2003. The net income results were consistent with managements
internal projections. Bankshares and TFB experienced growth across all of its
primary operating businesses, with growth in commercial and retail lending,
deposit accounts and core deposits, and assets under WMS management. During the
first quarter of 2003, TFB modified its loan pricing strategies and expanded
its loan product offerings in an effort to increase lending activity without
sacrificing the existing credit quality standards. The result of this has been
a 27.6% increase in net loan outstandings from June 30, 2003 to June 30, 2004.
Total deposits increased 12.5% from June 30, 2003 to June 30, 2004, with TFB
gaining in-market customers dissatisfied with the service and pricing resulting
from the consolidation of other local community banks into larger,
out-of-market financial institutions. WMS assets under management grew by $29.2
million to $228.6 million, or 14.6%, from June 30, 2003 to June 30, 2004, with
WMS revenue increasing from $435,000 to $633,000 or 45.7% for the respective
six month periods, as management focused more people, marketing, and other
resources toward the WMS business. Management continued the expansion of its branch network into southern Fauquier
County with a new branch which opened in Bealeton, Virginia during May of 2004.
Additionally, TFB looks to add to its branch network in western Prince William
County, as well as Fauquier County. TFB is looking toward these new retail
markets for growth in deposits and WMS income. Management also seeks to
increase the level of its fee income from deposits and WMS through the increase
of its market share within its current marketplace. 15
      COMPARISION OF OPERATING RESULTS FOR THE THREE MONTHS ENDED JUNE 30, 2004 AND
JUNE 30, 2003 NET INCOME.Net income for the three months ended June 30, 2004
was $1.08 million or $0.31 per diluted share compared with $946,000 or $0.27
per diluted share for the three months ended June 30, 2003. The $138,000 or
14.6% increase in net income for the quarter was fundamentally in-line with
management expectations. NET INTEREST INCOME.Net interest income increased $693,000 or 19.3% to $4.28
million for the three months ended June 30, 2004 compared with $3.59 million
for the three months ended June 30, 2003. The increase in net interest income
resulted from increased interest and fee income on loans as a result of the
increase in volume of loans outstanding. The net interest margin, computed on a
tax equivalent basis, for the June 2004 quarter was 4.62% compared with 4.63%
for the same quarter one year earlier. The decrease in the net interest margin
can be attributed primarily to the continuation of the low interest rate
environment, and the corresponding reduction in the average rate on earning
assets, which declined on a tax equivalent basis to 5.73% for the quarter ended
June 30, 2004, from 5.94% for the quarter ended June 30, 2003. Average
interest-earning assets grew 18.9% to $372.4 million for the second quarter of
2004 compared with $313.2 million for the second quarter of 2003. Total
interest income increased $702,000 or 15.2% to $5.32 million for the three
months ended June 30, 2004, compared with $4.62 million for the three months
ended June 30, 2003, as a result of the growth in interest-earning assets.
Interest and dividends on investment securities decreased $35,000 or 7.6%.
Investment securities averaged $47.7 million for the second quarter of 2004
compared with $62.5 million for the same quarter one year earlier. The yield
on investment securities was 3.61% on a tax-equivalent basis for the second
quarter of 2004, compared with 2.99% for the second quarter of 2003. Interest
and fees on loans increased $739,000 or 17.9% to $4.87 million for the June
2004 quarter compared with the same quarter one year earlier. Average loans
outstanding totaled $313.9 million and earned 6.21% on a tax-equivalent basis
for the quarter ended June 30, 2004, compared with $238.7 million and 6.96%,
respectively, for the quarter ended June 30, 2003. Total interest expense increased $9,000 or 0.9% to $1.04 million for the three
months ended June 30, 2004 from $1.03 million for the three months ended June
30, 2003. Average interest-bearing liabilities grew 15.9% to $291.4 million
for the second quarter of 2004 compared with $251.5 million for the second
quarter of 2003, while the average cost on interest-bearing liabilities
decreased to 1.43% from 1.64% for the same respective time periods. The
decrease in total interest expense and the average cost of interest-bearing
liabilities was due to the continuation of the low shorter-term interest rate
environment. Average certificates of deposit balances for the second quarter
of 2004 were $77.8 million at an average cost of 2.50%, compared with $80.8
million at an average cost of 2.70% for the same quarter one year earlier.
Interest-bearing NOW account deposits averaged $77.9 million at an average cost
of 0.69% for the June 2004 quarter, compared with $50.9 million at an average
cost of 0.20% for the June 2003 quarter. Both the growth in average balances
and the increase in the average cost was attributable to the introduction of a
new high balance, premium interest rate NOW account. Interest-bearing money
market deposits averaged $69.6 million at an average cost of 0.80% for the
quarter ended June 30, 2004, compared with $60.4 million at an average cost of
1.20% for the same quarter one year earlier. Savings account deposits averaged
$40.6 million at an average cost of 0.35% for the June 2004 quarter, compared
with $40.4 million at an average cost of 0.54% for the June 2003 quarter.
Average FHLB of Atlanta advances were $21.3 million at an average cost of 3.64%
for the second quarter of 2004, and $15.0 million at an average cost of 4.64%
one year earlier. Net interest income is the largest component of net income, and equals the
difference between income generated on interest-earning assets and interest
expense incurred on interest-bearing liabilities. Future trends regarding net
interest income are dependent on the absolute level of market interest rates,
the shape of the yield curve, the amount of lost income from non-performing
assets, the amount of prepaying loans, the mix and amount of various deposit
types, and many other factors, as well as the overall volume of
interest-earning assets. These factors are individually difficult to predict,
and when taken together, the uncertainty of future trends compounds. Based on
managements current projections, net interest income may increase in 2004 and
beyond as average interest-earning assets increase, but this may be offset in
part or in whole by a possible contraction in TFBs net interest margin
resulting from competitive market conditions. Additionally, TFBs balance sheet
is positioned for a stable or rising interest rate environment. This means that
net interest income is projected to increase if market interest rates rise, and
decrease if market interest rates fall. The specific nature of TFBs
variability in net interest income due to changes in interest rates, also known
as interest rate risk, is to a large degree the result of TFBs deposit base
structure. During the second quarter of 2004, demand deposits, NOW accounts,
and savings deposits averaged 24%, 22%, and 12% of total average deposits,
respectively, while the more interest-rate sensitive time certificates of
deposit averaged 22% of total average deposits. 16
      The following table sets forth information relating to Bankshares average
balance sheet and reflects the average yield on assets and the average
annualized cost of liabilities for the three month periods ended June 30, 2004
and 2003. These yields and costs are derived by annualizing the income or
expense for the periods presented, and dividing the product of the annualizaton
by the respective average daily balances of
assets and liabilities for the periods presented. AVERAGE BALANCES, INCOME AND EXPENSES, AND AVERAGE YIELDS AND RATES
(In Thousands) Three Months Ending June 30, 2004
    
    Three Months Ending June 30, 2003Average
    
    Income/
    
    Average
    
    Average
    
    Income/
    
    AverageBalances
    
    Expense
    
    Rate
    
    Balances
    
    Expense
    
    RateASSETS:LoansTaxable
    
    $
    305,108
    
    
    $
    4,771
    
    
    
    6.20
    %
    
    $
    229,329
    
    
    $
    4,011
    
    
    
    6.94
    %Tax-exempt (1)
    
    
    7,893
    
    
    
    143
    
    
    
    7.16
    %
    
    
    8,434
    
    
    
    174
    
    
    
    8.18
    %Nonaccrual
    
    
    915
    
    
    
    
    
    
    
    
    
    
    
    974
    
    
    
    Total Loans
    
    
    313,916
    
    
    
    4,914
    
    
    
    6.21
    %
    
    
    238,737
    
    
    
    4,185
    
    
    
    6.96
    %SecuritiesTaxable
    
    
    46,532
    
    
    
    409
    
    
    
    3.52
    %
    
    
    60,887
    
    
    
    440
    
    
    
    2.89
    %Tax-exempt (1)
    
    
    1,218
    
    
    
    22
    
    
    
    7.14
    %
    
    
    1,657
    
    
    
    28
    
    
    
    6.72
    %Total securities
    
    
    47,750
    
    
    
    431
    
    
    
    3.61
    %
    
    
    62,544
    
    
    
    468
    
    
    
    2.99
    %Deposits in banks
    
    
    1,298
    
    
    
    12
    
    
    
    3.56
    %
    
    
    151
    
    
    
    
    
    
    
    0.71
    %Federal funds sold
    
    
    9,472
    
    
    
    20
    
    
    
    0.85
    %
    
    
    11,808
    
    
    
    34
    
    
    
    1.13
    %Total earning assets
    
    
    372,436
    
    
    
    5,377
    
    
    
    5.73
    %
    
    
    313,240
    
    
    
    4,687
    
    
    
    5.94
    %Less: Reserve for loan losses
    
    
    (3,742
    )
    
    
    
    
    
    
    
    
    
    
    (3,035
    )Cash and due from banks
    
    
    18,807
    
    
    
    
    
    
    
    
    
    
    
    16,372Bank premises and equipment, net
    
    
    8,522
    
    
    
    
    
    
    
    
    
    
    
    7,528Other assets
    
    
    11,151
    
    
    
    
    
    
    
    
    
    
    
    9,294Total Assets
    
    $
    407,174
    
    
    
    
    
    
    
    
    
    
    $
    343,399LIABILITIES AND SHAREHOLDERS EQUITY:DepositsDemand deposits
    
    $
    84,741
    
    
    
    
    
    
    
    
    
    
    $
    62,589Interest-bearing depositsNOW accounts
    
    
    77,854
    
    
    
    133
    
    
    
    0.69
    %
    
    
    50,939
    
    
    
    25
    
    
    
    0.20
    %Money market accounts
    
    
    69,642
    
    
    
    138
    
    
    
    0.80
    %
    
    
    60,413
    
    
    
    181
    
    
    
    1.20
    %Savings accounts
    
    
    40,634
    
    
    
    36
    
    
    
    0.35
    %
    
    
    40,383
    
    
    
    55
    
    
    
    0.54
    %Time deposits
    
    
    77,763
    
    
    
    485
    
    
    
    2.50
    %
    
    
    80,800
    
    
    
    544
    
    
    
    2.70
    %Total interest-bearing deposits
    
    
    265,893
    
    
    
    792
    
    
    
    1.20
    %
    
    
    232,535
    
    
    
    805
    
    
    
    1.39
    %Federal funds purchased and securities sold under
agreements to repurchase
    
    
    110
    
    
    
    2
    
    
    
    8.92
    %
    
    
    
    
    
    
    
    
    
    
    0.00
    %Federal Home Loan Bank advances
    
    
    21,319
    
    
    
    196
    
    
    
    3.64
    %
    
    
    15,000
    
    
    
    176
    
    
    
    4.64
    %Capital Securities of Subsidiary Trust
    
    
    4,000
    
    
    
    48
    
    
    
    4.73
    %
    
    
    4,000
    
    
    
    49
    
    
    
    4.87
    %Total interest-bearing liabilities
    
    
    291,332
    
    
    
    1,038
    
    
    
    1.43
    %
    
    
    251,535
    
    
    
    1,030
    
    
    
    1.64
    %Other liabilities
    
    
    2,123
    
    
    
    
    
    
    
    
    
    
    
    2,032Shareholders equity
    
    
    28,988
    
    
    
    
    
    
    
    
    
    
    
    27,243Total Liabilities & Shareholders Equity
    
    $
    407,174
    
    
    
    
    
    
    
    
    
    
    $
    343,399Net interest spread
    
    
    
    
    
    $
    4,339
    
    
    
    
    
    
    
    
    
    
    $
    3,657Interest expense as a percent of average earning assets
    
    
    
    
    
    
    
    
    
    
    1.12
    %
    
    
    
    
    
    
    
    
    
    
    1.32
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    4.62
    %
    
    
    
    
    
    
    
    
    
    
    4.63
    %
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%. The amount of the
tax equivalent adjustment for the three month periods ending June 30, 2004 and 2003 is $56,000 and $69,000,
respectively. 17
      RATE/VOLUME ANALYSIS The following table sets forth certain information regarding changes in
interest income and interest expense of Bankshares for the three month periods
ended June 30, 2004 and 2003. For each category of interest-earning asset and
interest-bearing liability, information is provided on changes attributable to
changes in volume (change in volume multiplied by the prior period rate); and
changes in rate (change in rate multiplied by the prior period volume). Changes
which cannot be separately identified are allocated proportionately between
changes in volume and changes in rate. RATE / VOLUME VARIANCE
(In Thousands) Three Months Ending June 30, 2004 Compared withThree Months Ending June 30, 2003Due to
    
    Due toChange
    
    Volume
    
    RateLoans; taxable
    
    $
    760
    
    
    $
    1,122
    
    
    $
    (362
    )Loans; tax-exempt (1)
    
    
    18
    
    
    
    6
    
    
    
    12Securities; taxable
    
    
    (31
    )
    
    
    (411
    )
    
    
    380Securities; tax-exempt (1)
    
    
    (6
    )
    
    
    (8
    )
    
    
    2Deposits in banks
    
    
    12
    
    
    
    8
    
    
    
    4Federal funds sold
    
    
    (14
    )
    
    
    (6
    )
    
    
    (8
    )Total Interest Income
    
    
    739
    
    
    
    711
    
    
    
    28INTEREST EXPENSENOW accounts
    
    
    108
    
    
    
    19
    
    
    
    89Money market accounts
    
    
    (43
    )
    
    
    36
    
    
    
    (79
    )Savings accounts
    
    
    (19
    )
    
    
    
    
    
    
    (19
    )Time deposits
    
    
    (59
    )
    
    
    (20
    )
    
    
    (39
    )Federal funds purchasedFederal Home Loan Bank Advances
    
    
    2
    
    
    
    2
    
    
    
    Capital Securities of Subsidiary Trust
    
    
    20
    
    
    
    41
    
    
    
    (21
    )Total Interest Expense
    
    
    (1
    )
    
    
    
    
    
    
    (1
    )Net Interest Income
    
    
    8
    
    
    
    78
    
    
    
    (70
    )$
    731
    
    
    $
    633
    
    
    $
    98
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax
rate of 34%. The monitoring and management of net interest income is the responsibility of
TFBs Asset and Liability Management Committee (ALCO). ALCO meets no less
than once a month, and is comprised of TFBs senior management. 18
      PROVISION FOR LOAN LOSSES.The provision for loan losses was $154,000 and
$155,000 for the three months ended June 30, 2004 and 2003, respectively. The
respective amounts of the provision for loan losses were determined based upon
managements continual evaluation of the adequacy of the allowance for loan
losses, which encompasses the overall risk characteristics of the loan
portfolio, trends in TFBs delinquent and non-performing loans, estimated
values of collateral, and the impact of economic conditions on borrowers.
There can be no assurances, however, that future losses will not exceed
estimated amounts, or that additional provisions for loan losses will not be
required in future periods. Please refer to the section entitled Critical
Accounting Policies: Allowance for Loan Losses above for an explanation of the
allowance methodology. TOTAL OTHER INCOME.Total other income increased by $42,000 or 3.5% from $1.22
million for the three months ended June 30, 2003 to $1.26 million for the three
months ended June 30, 2004. This increase stemmed primarily from the $93,000 or
42.9% increase in revenues within TFBs WMS division. Service charges on deposit accounts increased $16,000, or 2.7% to $637,000 for
the quarter ended June 30, 2004, compared with $620,000 for the same quarter
one year earlier. Management had projected deposits on service charges to
increase essentially in proportion to the growth in transaction account
deposits, which grew approximately 12.5% from June 30 2003 to June 30, 2004.
This has not been the case during the first six months of 2004. The variation
from expectations was primarily due to the increase in the average retail
customers transaction deposit balances, which in turn lowered the number of
occurrences for honoring customer overdrafts resulting in lower associated
fees. Management has reduced its expectations with regard to the level of
growth on deposit account service charges over the next six months.
Additionally, the impact of Check 21 legislation on deposit account service
charges during the remainder of 2004 is difficult to predict. Signed by
President Bush on October 28, 2003 and effective October 28, 2004, the Check
Clearing for the 21st Century Act (Check 21) is designed to facilitate check
truncation by authorizing substitute checks, to foster innovation in the check
collection system without mandating receipt of checks in electronic form, and
to improve the overall efficiency of the nations payments system. Over the
long term, management believes that Check 21 may reduce service charges on
deposit accounts, but also reduce operational expenses. Management seeks to increase the level of its future fee income from WMS
through the increase of its market share within its marketplace. While WMS fees
grew 43% for the quarter ended June 30, 2004 compared with the quarter ended
June 30, 2003, WMS fees are not projected to continue to grow at the pace, but
are projected to stabilize during the remainder of 2004 and show more moderate
growth over the longer term. Income from Bank Owned Life Insurance (BOLI)
should be less in 2004 than 2003 due to the effect of the decline in market
interest rates over the last two years on the crediting rate for the BOLI.
Management is not projecting any sales of securities for the remainder of 2004. TOTAL OTHER EXPENSES.Total other expenses increased 16.1% or $532,000 to
$3.83 million for the three months ended June 30, 2004, compared with $3.30
million for the three months ended June 30, 2003, which was in-line with
managements internal projections. Salary and benefit expenses increased
$367,000, or 23.1% from the June 2003 quarter to the June 2004 quarter. The
primary cause for the growth in salary and benefit expense was the increase of
full-time equivalent employees from 125 at June 30, 2003 to 141 at June 30,
2004, as well as increases in the defined-benefit pension plan and medical
insurance expense, and customary annual salary increases. The growth in
full-time equivalent employees primarily reflects the opening of the Bealeton
branch and the growth in lending operations. Occupancy and furniture and
equipment expenses also increased over the same period by $10,000 or 4.6%, and
$18,000 or 6.0%, respectively, also primarily due to the opening of the
Bealeton branch. Other operating expenses increased $138,000 or 11.4%. The
growth in other operating expenses primarily reflects increases in legal and
consulting expenses, board of director compensation, and outsourced data
processing fees. The increase in legal and consulting fees can be attributed
to meeting the requirements of the Sarbanes-Oxley Act of 2002
(Sarbanes-Oxley), as well as the legal expenses associated with implementing
a dividend reinvestment plan. Please refer to the section entitled Capital
Resources below for further discussion on the dividend reinvestment plan.
Management expects the costs associated with Sarbanes-Oxley compliance to
increase in 2005 in connection with implementing the requirements of Section
404 regarding Managements Report on Internal Controls. 19
      TFB expects salary and benefits to continue to be its largest other expense. As
such, the most important factor with regard to potential changes in other
expenses is the expansion of staff. The cost of any additional staff expansion,
however, would be expected to be offset by the increased revenue generated by
the additional services that the new staff would enable TFB to perform. For the
remainder of 2004, TFB does not project to materially increase staff from its
current levels. During July 2004, TFB completed the renegotiation and signed a letter of
agreement with its outsourced data processing service provider, which,
contingent upon a legal review of the final contract, is projected to reduce
TFBs operating expenses by approximately $250,000 annually for the next five
years. COMPARISION OF OPERATING RESULTS FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND
JUNE 30, 2003 NET INCOME.Net income for the six months ended June 30, 2004 was
$2.15 million or $0.61 per diluted share compared with $2.04 million or $0.59
per diluted share for the six months ended June 30, 2003. The $117,000 or 5.7%
increase in net income for the six month period was fundamentally in-line with
management expectations with the exception of a $17,000 decline in service
charges on deposit accounts. NET INTEREST INCOME.Net interest income increased $1.21 million or 16.9% to
$8.37 million for the six months ended June 30, 2004 compared with $7.16
million for the six months ended June 30, 2003. The increase in net interest
income resulted from increased interest and fee income on loans as a result of
the growth in loans outstanding. The net interest margin, computed on a tax
equivalent basis, for the June 2004 six month period was 4.58% compared with
4.79% for the same six month period one year earlier. The decrease in the net
interest margin can be attributed primarily to the continuation of the low
shorter-term
interest rate environment, and the corresponding reduction in the average rate
on earning assets, which declined on a tax equivalent basis to 5.70% for the
six month period ended June 30, 2004, from 6.15% for the six month period ended
June 30, 2003, and outpaced the decline in interest-bearing liabilities by
0.28%. Average interest-earning assets grew 21.0% to $367.3 million for the first six
months of 2004 compared with $303.6 million for the first six months of 2003.
Total interest income increased $1.22 million or 13.2% to $10.43 million for
the six months ended June 30, 2004, compared with $9.21 million for the six
months ended June 30, 2003, as a result of the growth in interest-earning
assets. Investment securities income decreased $269,000 or 25.2%. Investment
securities averaged $49.3 million for the first six months of 2004 compared
with $66.7 million for the same six month period one year earlier. The yield
on investment securities was 3.30% on a tax-equivalent basis for the first six
months of 2004, compared with 3.26% for the first six months of 2003. Interest
and fees on loans increased $1.49 million or 18.3% to $9.59 million for the
June 2004 six month period compared with the same six month period one year
earlier. Average loans outstanding totaled $309.0 million and earned 6.22% on a
tax-equivalent basis for the six month period ended June 30, 2004, compared
with $230.2 million and 7.13%, respectively, for the six month period ended
June 30, 2003. Total interest expense increased $10,000 or 0.5% to $2.06 million for the six
months ended June 30, 2004 from $2.05 million for the six months ended June 30,
2003. Average interest-bearing liabilities grew 19.2% to $291.4 million for
the first six months of 2004 compared with $244.5 million for the first six
months of 2003, while the average cost on interest-bearing liabilities
decreased to 1.41% from 1.69% for the same respective time periods. The
decrease in total interest expense and the average cost of interest-bearing
liabilities was due to the continuation of the low shorter-term interest rate
environment. Average certificates of deposit balances for the first six months
of 2004 were $77.7 million at an average cost of 2.49%, compared with $76.5
million at an average cost of 2.79% for the same six month period one year
earlier. Interest-bearing NOW account deposits averaged $71.5 million at an
average cost of 0.59% for the six month period through June 30, 2004, compared
with $49.1 million at an average cost of 0.22% for the same respective period
one year earlier. Interest-bearing money market deposits averaged $68.6 million
at an average cost of 0.81% for the six months ended June 30, 2004, compared
with $59.2 million at an average cost of 1.27% for the same period one year
earlier. Savings account deposits averaged $40.5 million at an average cost of
0.36% for the six months ending June 30, 2004, compared with $40.0 million at
an average cost of 0.58% for the six months ending June 30, 2003. Average FHLB
of Atlanta advances were $23.8 million at an average cost of 3.39% for the
first six months of 2004, and $15 million at an average cost of 4.64% for the
same period one year earlier. 20
      The following table sets forth information relating to Bankshares average
balance sheet and reflects the average yield on assets and the average
annualized cost of liabilities for the six month periods ended June 30, 2004
and 2003. These yields and costs are derived by annualizing the income or
expense for the periods presented, and dividing the product of the annualizaton
by the respective average daily balances of
assets and liabilities for the periods presented. AVERAGE BALANCES, INCOME AND EXPENSES, AND AVERAGE YIELDS AND RATES
(In Thousands) Six Months Ending June 30, 2004
    
    Six Months Ending June 30, 2003Average
    
    Income/
    
    Average
    
    Average
    
    Income/
    
    AverageBalances
    
    Expense
    
    Rate
    
    Balances
    
    Expense
    
    RateASSETS:LoansTaxable
    
    $
    299,721
    
    
    $
    9,389
    
    
    
    6.21
    %
    
    $
    220,943
    
    
    $
    7,878
    
    
    
    7.11
    %Tax-exempt (1)
    
    
    8,360
    
    
    
    304
    
    
    
    7.20
    %
    
    
    8,352
    
    
    
    344
    
    
    
    8.20
    %Nonaccrual
    
    
    962
    
    
    
    
    
    
    
    
    
    
    
    933
    
    
    
    Total Loans
    
    
    309,043
    
    
    
    9,693
    
    
    
    6.22
    %
    
    
    230,228
    
    
    
    8,222
    
    
    
    7.13
    %SecuritiesTaxable
    
    
    48,021
    
    
    
    770
    
    
    
    3.21
    %
    
    
    65,019
    
    
    
    1,030
    
    
    
    3.17
    %Tax-exempt (1)
    
    
    1,229
    
    
    
    44
    
    
    
    7.10
    %
    
    
    1,689
    
    
    
    58
    
    
    
    6.82
    %Total securities
    
    
    49,250
    
    
    
    814
    
    
    
    3.30
    %
    
    
    66,708
    
    
    
    1,088
    
    
    
    3.26
    %Deposits in banks
    
    
    4,246
    
    
    
    18
    
    
    
    0.86
    %
    
    
    134
    
    
    
    1
    
    
    
    1.10
    %Federal funds sold
    
    
    4,773
    
    
    
    20
    
    
    
    0.85
    %
    
    
    6,480
    
    
    
    37
    
    
    
    1.13
    %Total earning assets
    
    
    367,312
    
    
    
    10,545
    
    
    
    5.70
    %
    
    
    303,550
    
    
    
    9,348
    
    
    
    6.15
    %Less: Reserve for loan losses
    
    
    (3,695
    )
    
    
    
    
    
    
    
    
    
    
    (3,009
    )Cash and due from banks
    
    
    16,651
    
    
    
    
    
    
    
    
    
    
    
    16,948Bank premises and equipment, net
    
    
    8,264
    
    
    
    
    
    
    
    
    
    
    
    7,014Other assets
    
    
    10,947
    
    
    
    
    
    
    
    
    
    
    
    7,740Total Assets
    
    $
    399,479
    
    
    
    
    
    
    
    
    
    
    $
    332,243LIABILITIES AND SHAREHOLDERS EQUITY:DepositsDemand deposits
    
    $
    77,171
    
    
    
    
    
    
    
    
    
    
    $
    58,887Interest-bearing depositsNOW accounts
    
    
    71,535
    
    
    
    211
    
    
    
    0.59
    %
    
    
    49,067
    
    
    
    54
    
    
    
    0.22
    %Money market accounts
    
    
    68,647
    
    
    
    277
    
    
    
    0.81
    %
    
    
    59,219
    
    
    
    372
    
    
    
    1.27
    %Savings accounts
    
    
    40,456
    
    
    
    73
    
    
    
    0.36
    %
    
    
    39,954
    
    
    
    114
    
    
    
    0.58
    %Time deposits
    
    
    77,687
    
    
    
    963
    
    
    
    2.49
    %
    
    
    76,526
    
    
    
    1,057
    
    
    
    2.79
    %Total interest-bearing deposits
    
    
    258,325
    
    
    
    1,524
    
    
    
    1.18
    %
    
    
    224,766
    
    
    
    1,597
    
    
    
    1.43
    %Federal funds purchased and securities
sold under
agreements to repurchase
    
    
    5,244
    
    
    
    34
    
    
    
    1.29
    %
    
    
    739
    
    
    
    5
    
    
    
    1.47
    %Federal Home Loan Bank advances
    
    
    23,754
    
    
    
    407
    
    
    
    3.39
    %
    
    
    15,000
    
    
    
    350
    
    
    
    4.64
    %Capital Securities of Subsidiary Trust
    
    
    4,000
    
    
    
    96
    
    
    
    4.79
    %
    
    
    4,000
    
    
    
    99
    
    
    
    4.94
    %Total interest-bearing liabilities
    
    
    291,323
    
    
    
    2,061
    
    
    
    1.41
    %
    
    
    244,505
    
    
    
    2,051
    
    
    
    1.69
    %Other liabilities
    
    
    2,009
    
    
    
    
    
    
    
    
    
    
    
    1,876Shareholders equity
    
    
    28,851
    
    
    
    
    
    
    
    
    
    
    
    26,975Total Liabilities & Shareholders Equity
    
    $
    399,479
    
    
    
    
    
    
    
    
    
    
    $
    332,243Net interest spread
    
    
    
    
    
    $
    8,484
    
    
    
    
    
    
    
    
    
    
    $
    7,297Interest expense as a percent of average
earning assets
    
    
    
    
    
    
    1.12
    %
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.36
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    4.58
    %
    
    
    
    
    
    
    
    
    
    
    4.79
    %
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%. The amount of the
tax equivalent adjustment for the six month periods ending June 30, 2004 and 2003 is $118,000 and $137,000, respectively. 21
      RATE/VOLUME ANALYSIS The following table sets forth certain information regarding changes in
interest income and interest expense of Bankshares for the six month periods
ended June 30, 2004 and 2003. For each category of interest-earning asset and
interest-bearing liability, information is provided on changes attributable to
changes in volume (change in volume multiplied by the prior period rate); and
changes in rate (change in rate multiplied by the prior period volume). Changes
which cannot be separately identified are allocated proportionately between
changes in volume and changes in rate. RATE / VOLUME VARIANCE
(In Thousands) Six Months Ending June 30, 2004 Compared toSix Months Ending June 30, 2003Due to
    
    Due toChange
    
    Volume
    
    RateLoans; taxable
    
    $
    1,511
    
    
    $
    2,343
    
    
    $
    (832
    )Loans; tax-exempt (1)
    
    
    (40
    )
    
    
    
    
    
    
    (40
    )Securities; taxable
    
    
    (260
    )
    
    
    (273
    )
    
    
    13Securities; tax-exempt (1)
    
    
    (14
    )
    
    
    (16
    )
    
    
    2Deposits in banks
    
    
    17
    
    
    
    17
    
    
    
    Federal funds sold
    
    
    (17
    )
    
    
    (9
    )
    
    
    (8
    )Total Interest Income
    
    
    1,197
    
    
    
    2,062
    
    
    
    (865
    )INTEREST EXPENSENOW accounts
    
    
    157
    
    
    
    34
    
    
    
    123Money market accounts
    
    
    (95
    )
    
    
    75
    
    
    
    (170
    )Savings accounts
    
    
    (41
    )
    
    
    1
    
    
    
    (42
    )Time deposits
    
    
    (94
    )
    
    
    15
    
    
    
    (109
    )Federal funds purchased
    
    
    29
    
    
    
    30
    
    
    
    (1
    )Federal Home Loan Bank Advances
    
    
    57
    
    
    
    106
    
    
    
    (49
    )Capital Securities of Subsidiary Trust
    
    
    (3
    )
    
    
    
    
    
    
    (3
    )Total Interest Expense
    
    
    10
    
    
    
    261
    
    
    
    (251
    )Net Interest Income
    
    $
    1,187
    
    
    $
    1,801
    
    
    $
    (614
    )
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%. PROVISION FOR LOAN LOSSES.The provision for loan losses was $308,000 and
$230,000 for the six months ended June 30, 2004 and 2003, respectively. Please
refer to the section entitled Critical Accounting Policies: Allowance for Loan
Losses above for an explanation of the allowance methodology. TOTAL OTHER INCOME.Total other income increased by $167,000 or 7.1% from
$2.35 million for the six months ended June 30, 2003 to $2.52 million for the
six months ended June 30, 2004. This increase is due to the $199,000 or 45.7%
increase in revenues within TFBs Wealth Management Services division.
Service charges on deposit accounts decreased $17,000, or 1.4% to $1.24 million
for the six months ended June 30, 2004, compared with $1.25 million for the
same six months one year earlier. 22
      TOTAL OTHER EXPENSES.Total other expenses increased 17.7% or $1.13 million to
$7.51 million for the six months ended June 30, 2004, compared with $6.38
million for the six months ended June 30, 2003, which was in-line with
managements internal projections. Salary and benefit expenses increased
$667,000 or 21.0% from the six months ending June 30, 2003 to the six months
ending June 30, 2004. The primary causes of the growth in salary and benefit
expense was the increase of full-time equivalent employees from 119 at the
beginning of 2003 to 141 at June 30, 2004, as well as increases in the
defined-benefit
pension plan and medical insurance expense, and customary annual salary
increases. Occupancy and furniture and equipment expenses also increased over
the same period by $13,000 or 3.1%, and $25,000 or 4.3%, respectively. Other
operating expenses increased $422,000 or 19.1%. The growth in other operating
expenses primarily reflects increases in director compensation, loan fees,
non-loan charge-offs, and outsourced data processing fees. COMPARISON OF JUNE 30, 2004 AND DECEMBER 31, 2003 FINANCIAL CONDITION Assets
totaled $414.5 million at June 30, 2004, an increase of 9.5% or $36.0 million
from $378.5 million at December 31, 2003. Balance sheet categories reflecting
significant changes include cash and due from banks, loans, federal funds sold
and federal funds purchased, and deposits. Each of these categories is
discussed below. CASH AND DUE FROM BANKS.At June 30, 2004, cash and due from
banks totaled $23.9 million, reflecting an increase of $12.1 million from $11.8
million at December 31, 2003. The increase in cash and due from banks was the
result of temporarily increasing TFBs deposits with the Federal Reserve Bank
of Richmond in order to satisfy reserve requirements. LOANS.Net loans were $316.3 million at June 30, 2004, which is an increase of
$21.0 million or 7.1% from $295.3 million at December 31, 2003. The growth in
total loans is primarily attributable to an increase of $9.8 million in
mortgage loans collateralized by 1-to-4 family residential real estate, an
increase of $7.5 million in mortgage loans collateralized by commercial real
estate, and an increase of $2.9 million in commercial and industrial loans.
TFBs loans are made primarily to customers located within TFBs primary market
area. During 2003 and continuing for the first six months of 2004, TFB modified
its loan pricing strategies and expanded its loan product offerings in an
effort to increase lending activity without sacrificing existing credit quality
standards. This was the primary reason for the increase in loans outstanding.
Management will continue to utilize the same pricing strategies for the
remainder of 2004, but does not project to originate the same level of 1-4
family residential real estate loans as it did in 2003 and the first six months
of 2004, primarily due to competitive pressures and market interest rates. FEDERAL FUNDS SOLD and FEDERAL FUNDS PURCHASED.Federal funds sold were $1.7
million at June 30, 2004, compared to federal funds purchased of $2.0 million
at December 31, 2003. DEPOSITS. At June 30, 2004, total deposits were $359.3 million, reflecting an
increase of $38.2 million or 11.9% from $321.1 million at December 31, 2003.
The growth was attributable to growth in noninterest-bearing deposits, which
increased $13.8 million, and growth in interest-bearing deposits, which
increased $24.4 million. Several factors may have contributed to the increase
in deposits. One factor was TFB gaining in-market customers who were
dissatisfied with the service and pricing resulting from the consolidation of
other local community banks into larger, out-of-market financial institutions.
Another factor may have been the increase in tax refunds flowing into bank
deposits. A third factor was gaining deposits from new customers at the
newly-opened Bealeton branch. TFB projects to increase its deposits in 2004 and
beyond through the continued expansion of its branch network, as well as by
offering value-added demand deposit products, and selective rate premiums on
interest-bearing deposits. ASSET QUALITY Non-performing assets, in most cases, consist of loans that
are 90 days or more past due and for which the accrual of interest has been
discontinued.
Management evaluates all loans that are 90 days or more past due, as well as
loans that have suffered financial distress, to determine if they should be
placed on non-accrual status. Factors considered by management include the
estimated value of collateral, if any, and other resources of the borrower that
may be available to satisfy the delinquency. 23
      TFB continues to have strong
credit quality as evidenced by non-performing assets totaling $968,000 or 0.30%
of total loans at June 30, 2004, as compared with $967,000, or 0.33% of total
loans at December 31, 2003, and $1.00 million, or 0.40% of total loans at June
30, 2003. The provision for loan losses was $308,000 for the first six months
of 2004 compared with $230,000 for the first six months of 2003. The 34%
increase in the provision for loan losses from June 30, 2003 to 2004 was
largely in response to the growth in new loan originations during the last 12
months, and, to a lesser extent, the continued uncertainty existing in the
economic and geopolitical environment. At June 30, 2004, the ratio of allowance for loan losses to total loans was 1.19% as compared with 1.20% at December 31, 2003 and 1.24% at June 30, 2003. Loans that are 90 days past due and accruing interest totaled $260,000 and
$840,000 at June 30, 2004 and December 31, 2003, respectively. No loss is
anticipated on these loans based on the value of the underlying collateral and
other factors. In addition, there are $6.8 million of performing loans that based on internal review and
classifications are considered to have a small potential for loss. Management has established specific reserves of $496,000 for these potential problem loans. There are no loans, other than those disclosed above as either
non-performing, impaired, or with potential problems, where known information about the borrower has caused management
to have serious doubts about the borrowers ability to repay the loan. There
are also no other interest-bearing assets that would be subject to disclosure
as either non-performing or impaired if such interest-bearing assets were
loans. To managements knowledge, no concentration of loans to borrowers
engaged in similar industries/activities exceeds 5% of total loans. The
largest concentrations of loans to borrowers engaged in similar activities are
$14.7 million for hotels/motels/inn loans, $14.1 million for land development
loans, and $10.0 million for child care facility loans. CONTRACTUAL OBLIGATIONS During July 2004, TFB completed the renegotiation and signed a letter agreement
with its outsourced data processing service provider, which, contingent upon a
legal review of the final contract, is projected to reduce TFBs operating
expenses by approximately $250,000 annually for the next five years. Aside from
this, as of June 30, 2004, there have been no material changes outside the
ordinary course of business to the contractual obligations disclosed in
Managements Discussion and Analysis in Bankshares Annual Report on Form
10-K for the year ended December 31, 2003. OFF-BALANCE SHEET ARRANGEMENTS As of June 30, 2004, there have been no material changes to the off-balance
sheet arrangements disclosed in Managements Discussion and Analysis in
Bankshares Annual Report on Form 10-K for the year ended December 31, 2003. CAPITAL RESOURCES Total shareholders equity was $28.9 million at June 30, 2004 compared to $28.5
million at December 31, 2003, an increase of $415,000, or 1.5%. During the six
months ended June 30, 2004, shareholders equity was decreased by $396,000 due
to the change in the accumulated other comprehensive income (loss)
(component. This represents the change in the market value of TFBs
available-for-sale securities portfolio from December 31, 2003 to June 30, 2004
net of tax. The change in market value was the result of purchases of
securities added to the portfolio, changes in market interest rates, and other
factors. In addition, TFBs shareholders equity was reduced $697,000 due to
the repurchase of 30,570 shares of Bankshares common stock at an average cost
of $22.54 during the first six months of 2004. Subsequent to June 30, 2004, Bankshares instituted a voluntary dividend
reinvestment plan (DRIP) for its shareholders through which shareholders may
purchase shares of common stock through the automatic reinvestment of their
dividends. Additionally through the DRIP, shareholders are also given the
opportunity to purchase additional shares of common stock up to specified
dollar amount limits. The DRIP may either buy existing shares in the open
market, or issue newly outstanding shares in order to fulfill its reinvestment
needs. Bankshares currently has registered 250,000 shares of common stock for
issuance under the DRIP. 24
      Banking regulations have established minimum capital requirements for financial
institutions, including risk-based capital ratios and leveraged ratios. Under
these guidelines, the $4.0 million of capital securities issued by Bankshares
subsidiary trust are treated as Tier 1 capital for purposes of the Federal
Reserves capital guidelines for bank holding companies, as long as the capital
securities and all other cumulative preferred securities of Bankshares together
do not exceed 25% of Tier 1 capital. Bankshares and TFB exceed their minimum
regulatory capital ratios. The following table sets forth the regulatory
capital ratio calculation for Bankshares: REGULATORY CAPITAL RATIOS
(in Thousands) June 30,
    
    December 31,2004
    
    2003Tier 1 Capital:Shareholders Equity
    
    $
    28,878
    
    
    $
    28,463Unrealized loss (gain) on securities
available for sale
    
    
    313
    
    
    
    (41
    )Less: Intangible assets, net
    
    
    (70
    )
    
    
    (83
    )Plus: Company-obligated madatorily
redeemable capital securities
    
    
    4,000
    
    
    
    4,000Total Tier 1 Capital
    
    
    33,121
    
    
    
    32,339Tier 2 Capital:Allowable Allowance for Loan Losses
    
    
    3,792
    
    
    
    3,511Total Capital:
    
    
    36,913
    
    
    
    35,850Risk Weighted Assets:
    
    $
    303,393
    
    
    $
    280,916Regulatory Capital Ratios:Leverage Ratio
    
    
    8.14
    %
    
    
    8.58
    %Tier 1 to Risk Weighted Assets
    
    
    10.92
    %
    
    
    11.51
    %Total Capital to Risk Weighted Assets
    
    
    12.17
    %
    
    
    12.76
    %
 25
      LIQUIDITY The primary sources of funds are deposits, repayment of loans, maturities of
investments, funds provided from operations and advances from the FHLB of
Atlanta. While scheduled repayments of loans and maturities of investment
securities are predictable sources of funds, deposit flows and loan repayments
are greatly influenced by the general level of interest rates, economic
conditions and competition. TFB uses its sources of funds to fund existing and
future loan commitments, to fund maturing certificates of deposit and demand
deposit withdrawals, to invest in other interest-earning assets, to maintain
liquidity, and to meet operating expenses. Management monitors projected
liquidity needs and determines the desirable funding level based in part on
TFBs commitments to make loans and managements assessment of TFBs ability to
generate funds. Cash and amounts due from depository institutions, interest-bearing deposits in
other banks, and federal funds sold totaled $25.8 million at June 30, 2004
compared with $12.0 million at December 31, 2003. These assets provide the
primary source of liquidity for TFB. In addition, management has designated the
entire investment portfolio as available of sale, of which approximately $42.3
million is unpledged and readily salable. Futhermore, TFB has an available
line of credit with the FHLB of Atlanta with a borrowing limit of approximately
$121.4 million at June 30, 2004 to provide additional sources of liquidity, as
well as
available federal funds purchased lines of credit with various commercial banks
totaling approximately $37.8 million. At June 30, 2004, $20.0 million of the
FHLB of Atlanta line of credit was in use. The following table sets forth information relating to Bankshares sources of
liquidity and the outstanding commitments for use of liquidity at June 30, 2004
and December 31, 2003. The liquidity coverage ratio is derived by dividing the
total sources of liquidity by the outstanding commitments for use of liquidity. LIQUIDITY SOURCES AND USES
(In Thousands) June 30, 2004
    
    December 31, 2003Total
    
    In Use
    
    Available
    
    Total
    
    In Use
    
    AvailableSources:Federal funds borrowing lines of credit
    
    $
    37,806
    
    
    $
    21
    
    
    $
    37,785
    
    
    $
    33,077
    
    
    $
    2,000
    
    
    $
    31,077Federal Home Loan Bank advances
    
    
    121,424
    
    
    
    20,000
    
    
    
    101,424
    
    
    
    60,540
    
    
    
    20,000
    
    
    
    40,540Federal funds sold
    
    
    
    
    
    
    
    
    
    
    1,740
    
    
    
    
    
    
    
    
    
    
    
    703Securities, available for sale and unpledged
at fair value
    
    
    
    
    
    
    
    
    
    
    42,288
    
    
    
    
    
    
    
    
    
    
    
    40,655Total short-term funding sources
    
    
    
    
    
    
    
    
    
    $
    183,237
    
    
    
    
    
    
    
    
    
    
    $
    112,975Uses:Unfunded loan commitments and
lending lines of credit
    
    
    
    
    
    
    
    
    
    $
    68,755
    
    
    
    
    
    
    
    
    
    
    $
    70,158Letters of credit
    
    
    
    
    
    
    
    
    
    
    10,308
    
    
    
    
    
    
    
    
    
    
    
    6,192Total potential short-term funding uses
    
    
    
    
    
    
    
    
    
    $
    79,063
    
    
    
    
    
    
    
    
    
    
    $
    76,350Ratio of short-term funding sources to
potential short-term funding uses
    
    
    
    
    
    
    
    
    
    
    231.8
    %
    
    
    
    
    
    
    
    
    
    
    148.0
    %
 Management is not aware of any market or institutional trends, events or
uncertainties that are expected to have a material effect on the liquidity,
capital resources or operations of Bankshares or TFB. Nor is management aware
of any current recommendations by regulatory authorities that would have a
material
effect on liquidity, capital resources or operations. TFBs internal sources
of such liquidity are deposits, loan and investment repayments, and securities
available for sale. TFBs primary external source of liquidity is advances from
the FHLB of Atlanta. 26
      RECENT ACCOUNTING PRONOUNCEMENTS There have been no additional accounting pronouncements by the Financial
Accounting Standards Board relevant to Bankshares other than those previously
described in Recent Accounting Pronouncements in Note 1 of the Notes to
Consolidated Financial Statements contained in Bankshares Annual Report on
Form 10-K for the year ended December 31, 2003. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have
been no material changes to the quantitative and qualitative disclosures made
in Bankshares Annual Report on Form 10-K for the year ended December 31, 2003. 
 ITEM 4. CONTROLS AND PROCEDURES As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers such as
Bankshares that file periodic reports under the Exchange Act of 1934 are
required to include in those reports certain information concerning the
issuers controls and procedures for complying with the disclosure requirements
of the federal securities laws. These disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by an issuer in the reports it files or
submits under the Exchange Act, is communicated to the issuers management,
including its principal executive officer or officers and principal financial
officer or officers, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure. We have established disclosure controls and procedures to ensure that material
information related to Bankshares is made known to our principal executive
officer and principal financial officer on a regular basis, in particular
during the periods in which our quarterly and annual reports are being
prepared. These disclosure controls and procedures consist principally of
communications between and among the chief executive officer and the chief
financial officer, and the other executive officers of Bankshares and its
subsidiaries to identify any new transactions, events, trends, contingencies or
other matters that may be material to Bankshares operations. The chief
executive officer and chief financial officer evaluated the effectiveness of
these disclosure controls and procedures as of the end of the period covered by
this report and, based on their evaluation, concluded that our disclosure
controls and procedures were operating effectively. Because of the inherent limitations in all control systems, no evaluation of
controls can provide absolute assurance that Bankshares disclosure controls
and procedures will detect or uncover every situation involving the failure of
persons within the organization to disclose material information otherwise
required to be set forth in Bankshares periodic reports. Bankshares management is also responsible for establishing and maintaining
adequate internal controls over financial reporting and control of Bankshares
assets to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. There were no changes
in Bankshares internal control over financial reporting or control of assets
during the quarter ended June 30, 2004 that have materially affected, or are
reasonably likely to materially affect, Bankshares internal control over
financial reporting or control of assets. 27
      Part II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS There are no pending or
threatened legal proceedings to which Bankshares or TFB is a party or to which
the property of either Bankshares or TFB is subject that, in the opinion of
management, may materially impact the financial condition of either company. 
 ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES Issuer Purchases of Equity Securities Total
    
    Average
    
    Total Number of
    
    Maximum Number ofNumber of
    
    Price
    
    Shares Purchased as
    
    Shares that May YetShares
    
    Paid per
    
    Part of Publicly
    
    Be Purchased UnderPurchased
    
    Share
    
    Announced Plan(1)
    
    the Plan(1)April 1  30, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    231,915May 1  31, 2004
    
    
    19,170
    
    
    $
    22.54
    
    
    
    19,170
    
    
    
    212,745June 1  30, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    212,745Total
    
    
    19,170
    
    
    $
    22.54
    
    
    
    19,170
    
    
    
    212,745
  (1)
    
    In September 1998, Bankshares announced an open market buyback program
for its common stock. Initially, the plan authorized Bankshares to
repurchase up to 73,672 shares of its common stock through December 31,
1999. Each year, the Board resets the amount of shares authorized to
be repurchased under the buyback program. On May 20,
2004, the Board authorized Bankshares
to repurchase up to 264,325 shares (8% of the shares of common stock
outstanding on January 1, 2003) beginning January 1, 2003 and
continuing until the next Board reset. Bankshares has repurchased 51,580 shares
under the current program from January 1, 2003 through June 30, 2004. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES None 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Bankshares held its Annual Meeting of Shareholders on May 18, 2004. A quorum
of Shareholders was present, consisting of a total of 2,679,227 shares, all
represented by proxy. At the Annual Meeting, the Shareholders elected Class II
directors Randy K. Ferrell, Stanley C. Haworth, Brian S. Montgomery, Harold P.
Neale, and Pat H. Nevill to three-year terms, and elected Class I director John
B. Adams, Jr. to a two-year term. The following Class I and Class III directors
whose terms expire in 2006 and 2005 continued in office: Alexander G. Green,
Jr., Douglas C. Larson, C. H. Lawrence, Jr., D. Harcourt Lees, Jr., Randolph T.
Minter, John J. Norman, Jr., H. Frances Stringfellow, and C. Hunton Tiffany.
The Shareholders also ratified the appointment of Yount, Hyde & Barbour, P.C.
as independent auditors of Bankshares for the year ending December 31, 2004. The vote on each matter was as follows:  1.
    
    For Directors: FOR
    
    WITHHELDJohn B. Adams, Jr.
    
    
    2,655,051
    
    
    
    24,176Randy K. Ferrell
    
    
    2,655,051
    
    
    
    24,176Stanley C. Haworth
    
    
    2,638,651
    
    
    
    40,576Brian S. Montgomery
    
    
    2,655,051
    
    
    
    24,176Harold P. Neale
    
    
    2,638,651
    
    
    
    40,576Pat H. Nevill
    
    
    2,670,227
    
    
    
    9,000
 28
      2.
    
    Ratification of the appointment of Yount, Hyde & Barbour, P.C. as the
independent
Auditors for Bankshares and TFB: FOR
    
    AGAINST
    
    ABSTAIN2,672,099
    
    1,148
    
    5,980
 
 ITEM 5. OTHER INFORMATION None 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits:3.1
    
    Articles of Incorporation of Fauquier Bankshares, Inc., as amended,
incorporated by reference to Exhibit 3(i) to registration statement on
Form 10 filed April 16, 19993.2
    
    Bylaws of Fauquier Bankshares, Inc., incorporated by reference to
Exhibit 3(ii) to registration statement on Form 10 filed April 16, 1999Certain instruments relating to capital securities not being registered
have been omitted in accordance with Item 601(b)(4)(iii) of Regulation S-K.
The registrant will furnish a copy of any such instrument to the Securities and
Exchange Commission upon its request.11
    
    Refer to Part I, Item 1, Footnote 5 to
the Consolidated Financial Statements.31.1
    
    Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)31.2
    
    Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)32.1
    
    Certification Pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer32.2
    
    Certification Pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer(b)
    
    Reports on Form 8-K:Current Report on Form 8-K, filed on April 23, 2004, furnishing a press
release announcing Bankshares results of operations for the quarter ended
March 31, 2004. 29
      SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. FAUQUIER BANKSHARES, INC.(Registrant)Dated: August 13, 2004
    
    /s/ Randy K. FerrellRandy K. Ferrell President and Chief Executive Officer(principal executive officer)Dated: August 13, 2004
    
    /s/ Eric P. GraapEric P. GraapSenior Vice President and Chief Financial Officer(principal financial and accounting officer)
 30